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Term Sheet Basics for Start-Ups – Part I
I.
How does the term sheet fit into the venture capital finance process?

When a venture capital (“VC”) investor decides to make an investment in a start-up
company, a term sheet is prepared for negotiation with the founder(s). Once the
terms are agreed upon, other legal documents, such as the Stock Purchase
Agreement and the Co-Sale Agreement, complete the equity purchase upon closing
and transfers the cash to the company.
II.

What is a term sheet? Why is it used?
A term sheet is a non-binding agreement outlining the basic terms and conditions
under which an investment will be made. It is typically used to develop legal
documents, such as the Stock Purchase Agreement, throughout the finance
process.1

A term sheet is essentially a letter of intent from the investors to the entrepreneurs
outlining the major points of future agreements. It typically details the amount of the
investment; how the equity is divided among the entrepreneurs, the investors, and
the future employees; the composition of the Board of Directors; and the special
rights of the investors.2

A term sheet is advantageous for two reasons:

First, the abbreviated format expedites the process. Attorneys are typically
familiar with the terms and expectations of the proposer when reviewing the term
sheet.
1
Term Sheet, at www.investopedia.com (June 15, 2001).
2
How Do I Start-Up? Frequently asked questions for the entrepreneur, at www.jgventures.com (June 15, 2001).
Copyright © 2002 Diamond Law Group, P.C. All Rights Reserved.

Second, since the term sheet doesn’t purport to be an agreement of any sort, it is
less likely that a court will find unexpected promissory content or that either party
will mistake the document to be some form of an enforceable agreement.3
III.

What terms are typically included?
The first part of the term sheet usually includes the principal features of the security
to be sold to the investors. The second part typically lists the principal features of the
purchase documents such as the Preferred Stock Purchase Agreement, the
Investor’s Rights Agreement, and the Co-Sale Agreement. 4
IV.
Which terms are typically negotiable?
Some examples of terms that may be subject to negotiation are the following:

Dividends may be negotiated to be cumulative and accruing, which are favorable for
the VC, instead of non-cumulative.

Liquidation preferences may be modified to allow investors to receive more than the
amount equal to their original investment and may also be participating preferences.

The redemption clause may be negotiated to redeem all at once, instead of over
time, which is unfavorable for the company.

Conversion can be modified to convert any time the investor chooses, and the VC
may not be forced to convert at the time of initial public offering, as was standard in
the former bull market.

Antidilution protection, which can seriously affect the start-up, can be written to be
full ratchet instead of partial or market ratchet, or as is more favorable for the startup, weighted. Full ratchet is particularly precarious for the company because if the
market declines further, the company may have to treat all Preferred Stock at the
latter, lower price and maybe forced to give investors additional shares for no
additional investment.

Board of Director composition is also an important term for negotiations. If the VC
has the upper hand, as they do in the current economic climate, then VC’s may
demand more seats on the company’s Board. The degree to which the VC controls
3
The Term Sheet, at www.vcexperts.com (June 19, 2001).
4
Halloran, M.J., Benton, L.F., Lovejoy, J.R., Venture Capital and Public Offering Negotiation, at 6-10 (Vol 2 2000
Supplement).
Copyright © 2002 Diamond Law Group, P.C. All Rights Reserved.
seats on the company’s Board could result in short-term difficulties for the company if
the Board intends to be actively involved in the company’s day-to-day operations.
Further, the composition of the Board could impact the long-term goals of the
company in such areas as: the company’s market targets, research and
development, and overall direction.
V.
How does the market influence term sheet negotiations?
Industry analysts have written extensively about the market slowdown in the
fourth quarter of 2000 and its failure to rebound in the first two quarters of 2001.
Nationally, venture capital investments have dropped 39% from the fourth quarter 2000
to the first quarter 2001, while VC investments have plummeted almost 50% between
the first quarter of 2000 and the first quarter of 2001.5 Headlines like “Retreat of the
VC’s”, “Venture funds venture less in tight economy” are indicative of the influence the
current market will have on term sheets and the company’s power to negotiate favorable
terms. While dividends, liquidation preferences, participation, antidilution, and Board
representation stipulations are standard in term sheets regardless of economic
conditions; the favorability or severity of the term conditions is often dictated by the
market climate.
Many of the terms are typically negotiable. However, because venture capitalist
money is currently limited, there is little competition among venture capitalists for startups. Therefore, VCs can negotiate tougher terms with companies in need of money.
For instance, in a pertinent business journal article, one venture capitalist states “[w]e
might get certain features in deals now that we might not have gotten last year…[s]ome
of the terms are a little more venture-capital friendly than they were last year.”6
VI.
Conclusion
With the term sheet in mind, a common question for the start-up company
seeking funding in today’s economic climate is "when will the venture capital market turn
around?" While there is no absolute answer, most economists and venture capitalists
Gove, Matt, Venture Capitalists’ Focus is on ‘Survival’, at
http://atlanta.bcentral.com/atlanta/stories/2001/05/14/story2. (May 11, 2001).; DeLong, Daniel F., Venture Funds
Venture Less in Tight Economy, at http://www.ecommercetimes.com/perl/printer/9773 (May 16, 2001).
5
Sumner, Gary, VC’s rising leverage seen in changing term sheets, at
http://atlanta.bcentral.com/atlanta/stories/2001/04/23/focus8 (April 20,2001).
6
Copyright © 2002 Diamond Law Group, P.C. All Rights Reserved.
are hoping for “at least partial recovery by the end of the year. It’s hopeful that by the
fourth quarter, you will have seen most of the correction and the venture money that has
been on the sidelines will get back in the game.”7 Additionally, history may provide hope
of a second-half rebound. “Historically, companies . . . have seen improved sales in the
last six months of the year”8 If, and when, this rebound occurs, VC term sheets may
become more company-friendly. In the meantime, start-up companies should be aware
of possible term conditions and be prepared to negotiate accordingly.
The foregoing content is for general information purposes only and is not intended to serve as legal advice in reference to any
particular matter. Please contact us for representation and/or further assistance in regard to your specific legal needs. Any liability
or attorney-client relationship that might arise from your use or reliance on the information contained in this memorandum is
expressly disclaimed. © 2002 Diamond Law Group, P.C. All Rights Reserved.
(footnote continued from previous page)
Gove, Matt, Venture Capitalists’ Focus is on ‘Survival’, at
http://atlanta.bcentral.com/atlanta/stories/2001/05/14/story2; (May 11, 2001).
7
8
The Starting Line: Tech picture not improving, at http://investor.cnet.com/investor/news. (June 13, 2001).
Copyright © 2002 Diamond Law Group, P.C. All Rights Reserved.